Oil drilling in the U.S. has transformed from hit-or-miss exploration to sure-thing production. Energy companies once relied on finding reachable pools of underground crude. Today, armed with new technology, they can simply squeeze the stuff out of pulverized shale using hydraulic fracturing, even if the deposits can't be reached from above. Volumes are gushing. Earlier this year, U.S. oil production topped seven million barrels per day for the first time since 1993. Analysts expected it to hit 10 million by 2020. For comparison, Saudi Arabia, the world's largest producer, puts out just over nine million barrels per day, albeit of purer crude.

SURGING OIL OUTPUT has done wonders for pipeline operators and their investors.
Kinder Morgan Energy Partners
(KMP), one of the largest players, has done more than twice as well as the Standard & Poor's 500 index over the past five years, returning an average of 13.3% a year. Increasingly, rails are getting a piece of the action, too. Originations of crude-oil shipments by rail soared 200% last year, according to Credit Suisse.

What rails lack in pricing they more than make up for in availability. Pipelines take years to build. Train tracks are already laid.
Stuart Goldenberg for Barron's

That's surprising, considering that trains are much more expensive than pipelines. Transporting a barrel of crude from the oil hub of Hardisty in Alberta, Canada, to the U.S. Gulf Coast, a major refining center, costs $7 to $11 using pipelines, but as much as $14 to $21 by rail, according to BMO Capital Markets. Every nickel per barrel matters for refiners, so under normal circumstances they'd balk at paying rail prices.

But North America's production glut has left landlocked crude some $20 per barrel cheaper than the imported stuff shipped to coastal refineries. Refiners are happy to pay $10 extra for transport to get the discount. And what rails lack in pricing, they more than make up for in availability. Pipelines take years to build and can run up against environmental squabbling. Train tracks are already laid, and no one complains about adding more cars and extra offloading facilities.

Canadian Pacific is uniquely positioned in that it can originate oil shipments from both Bakken shale and Canada's oil sands. The oil sands have three to four times the output potential of Bakken. And while rail's share of Bakken oil is expected to peak in late 2014 as new pipelines come online, pipeline capacity for Canada won't surge until 2015 at the earliest, and only then if the Keystone XL extension gets a timely nod from regulators. Even after Keystone, Canada will likely produce far more oil than pipelines can carry, and rails there have a key competitive advantage. The oil sands produce thick bitumen, which must be diluted to flow through pipelines, and then have the diluent removed at the refineries. Rails can simply glop bitumen into cars and deliver it to refineries—and on the way back, haul a load of diluent back to the pipelines for reuse.

Canadian Pacific, which is first in line to profit from both Bakken shale and Canada's the oil sands, trades at 21 times this year's profit forecast of $6.10 per share. But Wall Street expects those profits to swell to nearly $9 a share by 2015. Union Pacific is cheaper at 15 times 2013 earnings. It has interchange connections that allow it to pick up oil on its way from Bakken and Canada, and carry it to terminals near key refineries in Texas and Louisiana. It can also originate shipments from the Niobrara shale field in Colorado, Wyoming, Kansas, and Nebraska. Niobrara is less developed than Bakken, but production is likely to ramp up over the next five years.

Kansas City Southern, at 25 times projected 2013 earnings of $4.15 a share, has similarly attractive interchanges. It also owns land near major refineries in Port Arthur, Texas, and is working on a deal to turn it into a key terminal for northern crude. That could boost earnings from crude to $1 per share by 2015, says Landry, propelling earnings per share toward $7.

DON'T FORGET THE EAST COAST. Refiners there use pricey overseas crude and are eager to get their hands on cheap U.S. output. They have limited access to pipelines. Many are now extending rail lines and building high-speed unloading facilities. Rail oil capacity to the East should quadruple by 2014, according to BMO's Chamoun, and CSX and Norfolk Southern should benefit from picking up shipments that begin at Bakken or in Canada. Both are reasonably priced at 13 times earnings, and both have plenty of exposure to Eastern shale fields—the Utica field and Marcellus—and rising chemical production. They also have dividend yields of over 2%.

One risk to this newfound growth source for rails is that a plunge in oil prices would lead drillers to cut back on production, which would reduce the U.S. glut and thus, the price gap between U.S. and foreign crude. But so long as prices remain at $80 per barrel or higher, the U.S. discount will persist for years, says Fadel Gheit, an energy analyst for Oppenheimer. Brent (foreign) crude recently traded at $112 a barrel, while West Texas Intermediate (domestic) sold for $91.

A bigger risk for rails is simply that the U.S. economy falters, and shipments of all sorts of goods decline. But that's a risk for just about any stock. Compared with pipelines, rails offer a way to invest in soaring U.S. oil production without being singularly exposed to it.

Riding the Rails to Increased Profits

Refiners are ravenous for cheap domestic crude to replace pricey imports. These railroads are cashing in.

Company/Ticker

Mkt Val (bil)

Recent Price

P/E 2013E

Div Yield

What to Like

Canadian Pacific Railway/CP

$22.2

$127.21

21

1.1%

Unique geography; can originate shipments from Bakken and Canadian oil sands

CSX/CSX

23.4

22.71

13

2.5

Poised to connect Eastern refineries to cheap U.S. oil

Kansas City Southern/KSU

11.4

103.61

25

0.8

Connects northern rails with Gulf refineries; could develope land near Port Arthur, Texas, into key terminal